Comparison between Direct and Indirect Taxes (With Figure)

Allocative Effect:

It has been observed that the allocative effects of direct taxes are superior to those of indirect taxes.

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If a particular amount is raised through a direct tax like income tax, it would imply a lesser burden than the same amount raised through an indirect tax like excise duty.

This is because an indirect tax involves an excessive burden since it distorts the scale of preference due to price changes caused by its imposition. Thus, an indirect tax has a greater adverse effect on the allocation of resources than a direct tax.

It has been regarded that the sacrifice of economic welfare involved in paying a given sum of direct tax such as income tax will be relatively less than that of the same amount of an indirect tax like excise duty. Further, indirect or commodity taxation distorts consumers’ preference regarding goods, hence imposes an excessive real burden, in terms of sacrifice involved upon the tax payer. Direct taxes have no such distorting effect.

Using the technique of indifference curve, Professor Hicks and Miss Joseph have successfully demonstrated this excessive burden thesis as shown in Figure 2.

In Figure 2, the X-axis measures a commodity X. У-axis represents commodity Y or income of the individual. The original price line is AB. The consumer’s given money income is, thus, OA. Pre-tax equilibrium of the consumer is at point P, where the price line AB is tangent to the indifference curve IC3, which is the highest possible level of satisfaction attainable under the given situation. Thus, the consumer has ON of commodity X and OM of Y or income.

When a tax is imposed, the aim is to minimise the consumer’s sacrifice as far as possible.

Now, suppose an ad valorem excise duty is levied by the government on commodity X. As a result, the price of good X rises, say, from OA/OB1 to OA/OB1. Hence, we have a new price line AB1. The new equilibrium point P1 is then reached by the individual, so that he is placed on the indifference curve IC1. He buys OQ of X and OZ of У or income. He pays P1T amount as tax.

Now, let us see what happens if the same amount of tax P1T is raised through income tax (the direct tax). Thus, AD = P1T. So, after paying income tax, the line of disposable income will be drawn as D1. It is parallel to AB and passing through point P1.

The new equilibrium point, however, will be at P2. Under the convexity assumptions, from the consumer’s point of view, P2 is preferable to P1 though Р1 is also available as before. This is because at P2 a higher indifference curve IC2 is derived. So the consumer would be better off. The consumer, thus, buys ОС of X and OH of Y or income.

It follows that the sacrifice of satisfaction or disutility in the case of indirect tax is greater than the direct tax of equal amount. In fact, income tax is preferred to an excise duty by the individual because the former does not force any re-organisation of his choice while the latter tends to distort his preference and thereby makes him relatively worse off in terms of economic welfare.

The critics, however, argue that this purely theoretical case against indirect taxation is an illusion. A question has been raised: Does moving to a higher indifference curve really mean that the consumer is better off? D. Walker points out that here we have just assumed that the consumer feels himself better off when taxed directly rather than indirectly.

This, however, need not be so. On the contrary, it is likely that the consumer may be worse off, despite moving to a higher indifference curve. This can be understood from Pigou’s conception of economic welfare and total welfare.

Pigou has rightly visualised that economic welfare and total welfare need not always move in the same direction. When a person does not like to pay any tax, his real loss in total welfare cannot be just compensated by the fact that his loss of economic surplus is less in paying income tax than in excise duty. As such, looking to the total welfare criterion, the theoretical inference drawn under the indifference curve analysis appears to be wrong or illusory.

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Moreover, the Joseph-Hicks model has been over­simplified. It assumes perfect competition. It sees no impact of tax upon income or on the incentive to work. It begins from an idealistic situation where no tax has been imposed initially. If, however, these assumptions are removed, the model fails to work in real life.

The administrative costs of a direct tax are higher than those of an indirect tax, since a direct tax is narrow- based and grants many exemptions. Thus, in view of the administration cost, indirect taxes are relatively superior.

Again, from the viewpoint of efficiency and productivity, indirect taxes are better. Indirect taxes are wrapped up in prices, so they cannot be so easily evaded. Their cost of collection being the least, they are more productive.

On administrative grounds, it is found that indirect taxes are equally levied on every person, their collection is conveniently made in small amounts and their cost of collection is constant over time. Thus, indirect taxes are administratively easier to manage while direct taxes are relatively more difficult to administer.

Distributive Effect:

Direct taxes are regarded as superior to indirect taxes as an instrument of fiscal policy to reduce inequalities.

Being progressive, direct taxes can effectively narrow down the gap of inequalities. While being regressive in effect, indirect taxes may widen the gap of inequalities in the distribution of income and wealth.

But this is not always true. Even indirect taxes can be made progressive by levying them on luxuries and items of conspicuous consumption.

Thus, Prof. Prest puts that, “over a wide range, direct and indirect taxes are alternative methods of achieving any particular redistribution of income on which the government of the day may be bent.” This is because, “with indirect taxes the main method of adjustment will be the prices in the goods market and with direct tax as the rewards in the factor market. And this differing rate of adjustment does not in the least affect the general principle that we can attain any given re-distribution either way.”

Built-in Flexibility:

Direct taxes possess a greater degree of built-in flexibility than indirect taxes. During a period of prosperity, direct taxes like income tax and corporate profit tax fetch more revenue to the exchequer with the expansion of the country’s national income and general earnings of the people, since these taxes are progressively levied.

While commodity taxes being proportional in nature, do not fetch more revenue in comparison to the former. Being progressive in nature, direct taxes thus automatically take away the excessive purchasing power from the people during inflation and help in reducing the inflationary pressure, thereby fulfilling the stabilisation function of public finance very well.

During inflation, indirect taxes like excise duties and sales tax on goods prove to be inflationary. Thus, from the economic stabilisation point of view, direct taxes are preferred to indirect taxes.

Growth Orientation:

Modern government aims at a higher economic growth and attainment of full employment through its fiscal operations. In this regard, indirect taxes have an edge over direct taxes. Indirect taxes can entail a high degree of growth orientation than direct taxes. Direct taxes being progressive in nature cut into the incomes and savings of the people.

Direct taxes, thus, discourage saving. Saving is the main source of capital formation in the private sector. When savings and investments are discouraged, economic growth process is obstructed. Thus, in a mixed economy, a highly progressive direct taxation is not conducive to economic growth. Indirect taxes, on the other hand, rest on consumption.

Through indirect taxes, consumption can be discouraged and savings can be increased. Progressive indirect taxes on luxuries can reduce conspicuous consumption and restrict the scope of unproductive or socially undesirable investments and release resources which may be channelised into growth-oriented planned programmes.

In short, indirect taxes are regarded as superior to direct taxes in the following respects:

1. Their effect on incentive to work and save is not so harmful.

2. They can discourage conspicuous consumption and release resources for capital formation.

3. They can promote social morale and public health by restricting undesirable consumption.

4. They are not always regressive in effect. In fact, a proportionately charged direct tax is more regressive in effect than an indirect tax. Further, repressiveness of indirect taxes depends on the nature of the tax. If necessaries are taxed, the effect is regressive. But if luxuries are taxed, the effect is progressive.

5. By judicious measures, it is possible to reduce the evils of indirect taxes.

Bastable, therefore, concludes that a system of indirect taxation within narrow limits is better than direct taxation whenever large revenue is to be fetched.

We may not, however, fully agree with Bastable’s view, though we may admit that the use of indirect taxes is indispensable in modern public finance.